What the Deficit Supercommittee Could Do to the Dollar

Think the European debt crisis is roiling the markets? Wait until investors start focusing on the deficit SWAT team.

Until this morning, the euro was more or less holding up despite the turmoil in Europe, and that has flummoxed some investors. Mark McCormick, a strategist at Brown Brothers Harriman has a reason for the robustness: the deep divisions on the deficit supercommittee.

McCormick says markets are pricing in only a 7% probability that the supercommittee will reach a deal by its November 23 deadline. And if they don't, that means $1.2 trillion in discretionary spending cuts.

Why should currency investors care? Because that kind of tight fiscal policy, combined with sluggish economic growth, could push the Federal Reserve to be more accommodative. And "standard macro economic framework for currency analysis indicates restrictive fiscal policy, together with expansionary monetary, on average, tends to lead to domestic currency weakness," McCormick wrote in a note to clients. In essence, no deal means no dollar strength.

McCormick and his colleagues still expect the euro to hit 1.29 against the dollar by the end of the year, given all the troubles there. But if the supercommittee can't get itself together, and the cuts ensue, "you'd have the economy contracting and low relative interest rates, and that's basically toxic for a currency," he told me. The British pound, the euro and the dollar might "still be fighting it out for the ugly contest," he adds, so the dollar might not weaken so much against those two. But McCormick says it's quite possible that peripheral G10 currencies would nicely outperform the dollar.

Just something to keep in mind in case you don't have enough currency news to chew over right now.

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